MEASURING BUSINESS PERFORMANCE - ECONOMIC PROFIT

Companies use financial analysis to measure and improve business performance, but there are a lot of financial ratios and measures out there, and it is not always clear what you should focus on. For monitoring financial performance, I suggest you include Economic Profit as a key performance measure.

For most companies, Economic Profit is a better measure of business performance than profit. To illustrate this, let's say that you invested some money in a company which manufactures shoes. With your investment, the company bought a factory and some equipment and began manufacturing and selling their product. In the last year, the company made $100K in profit. Is $100K in profit good? As an investor, are you pleased with this performance?

It's hard to answer these questions with the information we've given, so let's also say that your investment in the company was $2M. Furthermore, there are many similar companies that you could invest in, and these companies are expected to generate a 12% annual return on your investment. Had you invested your $2M elsewhere, you would have expected $240K in annual profits ($2M x 12% return). Now let's answer the question: is the $100K in profit from the shoe manufacturer good? As an investor, are you pleased with this performance?

The answer here is clearly no. You require $240K in annual profit from this investment, but the shoe manufacturer only generated $100K. So, you have lost $140K vs. your required profit ($100K - $240K). This $140K loss is your Economic Profit.

Economic Profit is the difference between the actual profit and the required profit (profit - required profit). Furthermore, the required profit depends on the amount invested and the rate of return that the investor would expect to get from other, similar investments.

Clearly, Economic Profit packs a lot of information into one single number. For most companies, it is a better measure of business performance than profit, because Economic Profit tells you the amount by which a company's profit is outperforming other investment opportunities.